2021, the peak year for the IBOR transition process, is fast approaching. A major milestone has just been reached with ISDA’s publication of its IBOR Fallbacks Protocol for derivatives (links to the documents and resources ISDA has published are included at the end of this blog). But publication of the Protocol marks the start of a process, not the end of one. It is now time for banks to put in place an effective communications strategy to help ensure wide consideration of uptake, and to ensure that they are operationally ready to implement the fallback rates in their systems.
The Protocol is a crucial part of the transition away from IBORs in the derivatives market. The Protocol makes it possible for market participants to amend derivative contracts between adhering parties en masse, in order to incorporate references to the ‘fallback’ rates (such as SONIA and SOFR) that stand ready to take the place of IBORs. It is set to become effective on 25 January 2021, meaning that as and when various IBORs are discontinued from this date onwards, the fallbacks specified in ISDA’s documentation will automatically replace the discontinued rate within adhering contracts.
The beauty of the Protocol is that adherence is a matter of financial markets participants simply agreeing that the relevant contracts with other adherents be governed by its provisions. This removes the need for mass bilateral renegotiations (though some caution needs to be taken on the exact derivative products and currencies to which the Protocol applies, and bilateral negotiations may still be needed for some contracts). Firms become adherents by delivering an ‘Adherence Letter’ to ISDA, and can also submit Adherence Letters as agents on behalf of clients. A list of adherents is available online, with over 250 adherents already visible, including numerous global systemically important banks and their subsidiaries, and a number of central banks including the Bank of England.
The success of the Protocol as a mechanism to enable a smooth transition away from LIBOR depends on the levels of uptake in the market, and this makes the next few months of communication and client outreach critical. Sell-side firms will be keen for the widest possible uptake, but blanket buy-side participation is not a given, particularly when considering the varying degrees of awareness of transition and the Protocol that continues to exist in buy-side firms, across industries and jurisdictions. Notably, where adherence to the Protocol is not agreed, bilateral negotiations will be needed. Clarity of communication is therefore an absolute necessity in the coming months. Those firms that have done a good job to date in communicating with customers on IBOR transition might reasonably expect a smoother process of Protocol uptake. However, firms whose communications have been less successful thus far can expect more questions about the Protocol – what it is, how it works, what it entails for their contracts, and more.
Of course, with the Protocol becoming effective on 25 January 2021, industry does not need to have everything up and running as of tomorrow, but firms need to be ready to go in time. First and foremost, this means client‑facing staff being in a position to have the necessary customer conversations, as well as updating FAQs and other explanatory content for clients.
The challenges of widespread client communications notwithstanding, getting people to sign up is the relatively ‘easy’ part of the process. Beyond securing agreement from clients to become Protocol adherents, all market participants also need to be ready to implement the fallback rates in their systems, so that as and when given IBOR tenors and currencies are removed from the market the new rates are operational in systems and processes (for instance, from end-to-end in the booking model). Regardless of industry, all affected firms should at a minimum have their implementation journey mapped out so that they are confident in their ability to work with the fallbacks when needed next year, and buy-side firms and non-financial corporates in particular should not be reliant on the sell-side to make these aspects of the transition easier. As a next step, firms should familiarise themselves with the intended fallbacks, their calculation mechanisms, and understand how suited their technology and control environments are to handling these, planning remediation where needed.
It is also important to recognise that the ISDA protocol only covers the derivatives market, while the cash/debt market does not have an equivalent solution in place as yet. For derivatives hedging cash products, the use of the Protocol will need to be analysed as part of managing a smooth transition, managing basis risk and limiting value transfer, and there may still be a need for bilateral negotiations to address these issues.
2021 is set to be a big year, and there remains much to do to ensure that the IBOR transition takes place as intended. Obstacles remain, not least of which is corporate engagement with the process, as well as how the FCA will use its forthcoming powers to deal with ‘tough legacy’ products. But publication of the ISDA Protocol represents real progress, and has significant potential to accelerate and simplify the transition process. All market participants should now focus their attention on maximising this potential, and position themselves to navigate the transition smoothly.
Documents and resources published by ISDA:
- The supplement with amendments to 2006 ISDA definitions, setting out the various fallback rates for each IBOR
- The protocol to which counterparties would agree if wanting to adhere to the fallbacks
- An FAQ
- Template bilateral forms for counterparties to determine the manner in which the Protocol will apply to existing contracts, along with descriptions of these templates
- A video introduction to benchmark fallbacks